QUALITY DIFFERENTIATION AND HETEROGENEOUS CONSUMER PREFERENCES By DANIEL TORO GONZÁLEZ A dissertation submitted in partial fulfillment of the requirements of the degree of DOCTOR OF PHILOSOPHY WASHINGTON STATE UNIVERSITY School of Economic Sciences MAY 2012 To the Faculty of Washington State University: The members of the Committee appointed to examine the dissertation of DANIEL TORO GONZÁLEZ find it satisfactory and recommend that it be accepted. ___________________________________ Jill J. McCluskey, Ph.D., Chair ___________________________________ R. Karina Gallardo, Ph.D. ___________________________________ Ron C. Mittelhammer, Ph.D. ___________________________________ Jia Yan, Ph.D. ii ACKNOWLEDGEMENTS My sincere thanks go to the members of my committee Jia Yan, Karina Gallardo and Ron Mittelhammer, for your support, dedication, patience and guidance during all these years. Special thanks to Jill McCluskey, professor, advisor, committee chair and friend, who always has wise advice at hand. All of you contribute, not just to make me a better professional, but a better person. I would like to acknowledge the Fulbright Commission, Fulbright Colombia and Laspau, especially Lisa Tapiero for her kindness, advice, and help. It is an honor to be a Fulbrighter. I would like to thank all the staff and faculty at the School of Economic Sciences, for your support, kindness and willingness to help. I owe sincere and earnest thankfulness to my fellow students at the School of Economic Sciences, especially those who attended my presentations several times, with the best spirit of collaboration to help me to improve my papers and my presentation skills. I would like to show my gratitude to Patricia Martínez and all the members of the Universidad Tecnológica de Bolívar that gave me their support and made possible this extraordinary journey. I am in debt with Adolfo Meisel Roca who has always shown me his complete support in any academic endeavor. I would like to thank all of the “Latino Community” in Pullman for keeping me in touch with my roots and helping me feel closer to home and surrounded by family, especially during Christmas seasons. These acknowledgments would not be complete without recognizing the role of my always supportive family, especially my parents who taught me the value of hard work, and by their example gave me the strength to continue. I am truly indebted and thankful to Marina Pelaez y Martha Elena Toro who trusted in me from the beginning. Finally to Ericka, partner, friend, and wife, who many times patiently pick up my pieces and with all her love and comprehension put them back together. Especially dedicated to Cecilia and Lola. GO COUGS!! iii QUALITY DIFFERENTIATION AND HETEROGENEOUS CONSUMER PREFERENCES Abstract by Daniel Toro González, Ph.D. Washington State University May 2012 Chair: Jill J. McCluskey This dissertation consists of three independent but related papers. All of them are devoted to estimate demand functions in presence of unobservable product attributes, such as quality, using different identification strategies. The first two exercises are based on a discrete choice model using the product-market approach developed by Berry (1994) with aggregate data information for gum and beer consumption. The third paper uses a control function approach as an identification strategy in order to estimate the choice model using disaggregated (micro level) data on household choices. These exercises reveal the importance of controlling for price endogeneity due to the existence of unobservable product attributes incorporating substantial bias in the coefficients when ignored. iv TABLE OF CONTENTS Page ACKNOWLEDGEMENTS ........................................................................................................... iii LIST OF TABLES ........................................................................................................................ vii LIST OF FIGURES ..................................................................................................................... viii I. Introduction ................................................................................................................................. 2 II. Quality Differentiation with Flavors: Demand Estimation of Unobserved Attributes .............. 5 1. Introduction ............................................................................................................................. 6 2. Data ........................................................................................................................................ 10 3. Empirical Framework ............................................................................................................ 13 3a. Multinomial and Nested Logit Models Setup ................................................................ 15 3b. Instruments ..................................................................................................................... 20 4. Estimation Results ................................................................................................................. 22 4a. Counterfactual Exercises ..................................................................................................... 25 5. Conclusions ........................................................................................................................... 26 6. Chapter References ................................................................................................................ 28 III. Substitution between Micro and Macro Brews ....................................................................... 39 1. Introduction ........................................................................................................................... 40 2. Alcoholic Beverages in the Literature ................................................................................... 42 2.a. Consumer Preferences ........................................................................................................ 42 3. Data ........................................................................................................................................ 44 4. Modeling Framework ............................................................................................................ 47 5. Estimation Results ................................................................................................................. 53 6. Conclusions ........................................................................................................................... 58 7. Chapter References ................................................................................................................ 60 IV. Demand for Gum: Unobserved Flavor Quality Using Control Function Approach .............. 75 1. Introduction ........................................................................................................................... 76 2. Empirical Framework ........................................................................................................... 80 v 2.a. Control Function - Pricing Equation ................................... Error! Bookmark not defined. 2.b. Empirical Model: Mint Gum Demand ................................ Error! Bookmark not defined. 3. Control Function Specification .............................................................................................. 83 4. Data ........................................................................................................................................ 86 5. Estimation Results ................................................................................................................. 89 5.a. Random Coefficients Model............................................................................................... 91 6. Conclusions ........................................................................................................................... 92 7. Chapter References ................................................................................................................ 93 vi LIST OF TABLES CHAPTER TWO Table 1. Definition of Variables and Summary Statistics………………………………...31 Table 2. Gum Producers Market Shares by Quarter (2005)………………………………32 Table 3. Price Distribution of Gum by Flavor…………………………………………….33 Table 4. Mint Flavors Market Shares and Prices………………………………………….34 Table 5. Gum Demand Estimation Results………………………………………………..35 Table 6. Coefficients of Product Similarity within Groups……………………………….36 CHAPTER THREE Table 1. Product Descriptive Statistics………………………………………...……….....68 Table 2. Descriptive Statistics of Consumer’s Characteristics .…………………………..69 Table 3. Estimation Results……………………………………………………………….70 Table 4. Estimated Elasticities.……………………………………………………………71 Table 5. Confidence Intervals for Price Coefficients 95%.……………………………….72 Table 6. Results from other Studies..................................................................................73 CHAPTER FOUR Table 1. Descriptive Statistics……………………………………………………….….102 Table 2. Estimation results of the Choice Model……………………………………….103 Table 3. Scaled Coefficients…………………………………………………………….104 Table 4. Price Elasticities by Flavor …………………………………………………....105 vii LIST OF FIGURES CHAPTER TWO Figure 1. Mint Flavor Products: Prices and Estimated Quality………………………….37 CHAPTER THREE Figure 1. Evolution of the number of brewing firms (Micro Vs. Macro)………………..66 Figure 2. Elasticity Dynamics